I have great respect for many in academia. Some of them actually know what they are talking about. However, I am dismayed whenever I read poor reasoning and a faulty interpretation of data by someone passing themselves off as an expert. It tarnishes the image of academics everywhere.
When economists who have no idea what they are talking about get published, it diminishes the entire profession. The gentleman I am picking on today simply has no concept of the underlying causes and motivations of real estate market participants. To start, I want to show one example of his lack of understanding with a paper he wrote about commercial real estate.
A few economists have likened the commercial real estate market of the last 10 years to the housing cycle. In fact, the commercial and housing markets were fundamentally different.
As recently as last week (see also here), Paul Krugman claimed that the commercial real estate market followed a bubble much like that of the housing market, and thereby concluded that the housing bubble could not be blamed on anything unique to the housing sector.
Mr. Krugman observed that real estate prices went up, and then came down, in both the residential and nonresidential sectors. For example, he has presented the chart below comparing the Case-Shiller index for housing prices with a commercial real estate price index from Moody’s.
In Mr. Krugman’s view, both “bubbles” had some of the same determinants. For example, lenders were hungry for risk, and they fed their appetites by investing in a variety of assets, like houses and office buildings. Thus, he takes comfort in his observations that the two sectors had real estate prices that moved roughly together. Continue reading →
A recent Harvard study concluded, "the boom and bust in housing over the last decade was not primarily caused by low interest rates, reduced downpayment requirements, or laxer underwriting standards"
The wisdom of song lyrics eludes everyone in a market rally. Prices can only rise so fast in a stable market. Fundamental constraints can be ignored for a time, but wicked bear markets signal their return when the collective insanity that grips the market wanes.
Academics study the problem, but so far, progress in the field of economics has been very slow and prone to decades long wastes of time on theories like Efficient Markets. Greed and fear are the features that move market prices. What we really need is to learn how to cool the engines; instead, we strive to go faster and we blow the engine apart.
Cambridge MA. — Contrary to the assertions of many economists and others, the boom and bust in housing over the last decade was not primarily caused by low interest rates, reduced downpayment requirements, or laxer underwriting standards, conclude Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko in “Did Credit Market Policies Cause the Housing Bubble?” a new Policy Brief published by the Rappaport Institute for Greater Boston and the Taubman Center for State and Local Government at the John F. Kennedy School of Government at Harvard University.
… “It isn’t that higher mortgage approval rates aren’t associated with rising home values. They are,” they add. “But the impact of these variables, as predicted by economic theory and as estimated empirically over many years, is too small to explain much of the housing market event that we have just experienced.” Specifically, the authors found that the 1.3 percentage point drop in real interest rates between 2000 and 2006 was responsible for only a 10 percent rise in prices, about a third of the average price increases nationally during that time and even a smaller share of the increase in many metropolitan areas, including greater Boston, where prices rose by 54 percent between 2000 and 2006.
I reached the same conclusion when researching the Great Housing Bubble. With a spreadsheet, anyone can input the income data, apply the appropriate debt-to-income ratio and calculate what a proper loan would have been. Add an appropriate 20% down payment, and you arrive at what houses should sell for. This simple math predicts housing prices in less volatile markets. Prices deviate from expectations when irrational exuberance takes over.
If banks didn't allow DTIs above 25%-32%, we would not inflate housing bubbles. In the late 1970s, lenders allowed DTIs to go well over this safe range because both the lenders and the borrowers anticipated more wage inflation. A borrower can take on a 60% DTI if they believe they will be making 10% more in salary each and every year. In a few years, the DTI would be under 30% and falling quickly. In the face of rising wage inflation, taking on debt at fixed interest is very attractive. This is the trap of inflation expectation the Federal Reserve had to bring under control under Paul Volcker.
Our latest housing bubble was built on a different mechanism: the toxic loan. DTIs were again allowed to rise above the stable range because the terms of repayment provided borrowers with a manageable DTI on a temporary basis. First it was the interest-only loan, then it was the Option ARM. Once lenders started making loans based on the temporary affordability these loans provided, they inflated a massive housing bubble sure to deflate once the unstable loan terms blew up. The terms of the toxic loans were the direct cause of the housing bubble. The reduced underwriting standards merely allowed lenders to give toxic loans to more people and make the bubble go on a little longer.
Glaeser, Gottlieb and Gyourko did find that the price effect of interest rates was greatest in metropolitan areas such as Boston, San Francisco, New York, and Seattle that have less land, more regulation and/or topography that is not conducive to new buildings. However, that impact was not enough to explain the full magnitude of the housing bubble in those places. They estimate, for example, that reduced interest rates should have caused prices in greater Boston to rise by about 14 percent between 2000 and 2006, significantly less than the actual increase of 54 percent.
The authors also found that contrary to the assertions of many analysts, including Benjamin Bernanke, chairman of the Board of Governors of the Federal Reserve System, reduced downpayment requirements did not greatly contribute to the housing bubble. Rather, they found that on average the share of the purchase price covered by a mortgage was basically unchanged over the course of the boom, rising from about 84 percent in 1998 (before the boom began) to 88 percent at the peak of the bubble in 2006 and then dropping to about 80 percent by 2008 after the bubble had burst. Moreover, the changes were even smaller among the share of people who borrowed as much as possible. Nationally, in 1998 one-quarter of home purchasers put down only about 96 percent of the total purchase price; by 2006 this figure had risen to 99 percent.
While the data do not explain the housing bubble, the authors do contend that the “the relatively modest link between interest rates and housing prices makes us more confident about rethinking [other] Federal housing policies,” most notably the ability to deduct mortgage interest from federal income taxes, a politically popular policy that many analysts believe is inefficient, unfair, and environmentally unsound. They also suggest that states such as Massachusetts that have restrictive local land use laws could reduce the extremity of its housing price cycles via policies that supersede local zoning or reward communities that allow for more housing.
I like their two policy recommendations, but neither one has any chance of passage.
Diana Olick didn't see the wisdom in this study either, and I will let her have the first shot.
"Contrary to the assertions of many economists and others, the boom and bust in housing over the last decade was not primarily caused by low interest rates, reduced down payment requirements, or laxer underwriting standards."
My sixth grade English teacher always told me never to start with a quote, but in this case, how could I not?
Read it again, if you will; I read it three times just to make sure.
Yes, after years of bashing the mortgage industry for lax underwriting, bashing the Federal Government for negligently low interest rates and blaming investors for vacuuming up homes with no-money-down loans, three guys from Harvard say they're all off the hook.
Thank you, Diana. I am not the only one dumfounded at the ignorance of their assertions.
…I found a lot of this quite hard to digest, given the debate I've been covering for the last four years, from peak to trough to recovery. So I called Prof. Glaeser, who very affably took my questions.
Diana: If loose lending and over-borrowing didn't cause the housing bubble, what did?
Prof. Glaeser: The historical relationship between these variables and the housing market is just to small to explain this. In terms of understanding it, we believe that neither we nor anyone else understands this. The mechanics of bubbles, they certainly are associated with all sorts of irrational exuberant beliefs of future price changes. That's' always been true of housing. What specifically caused this thing? A strange cocktail that brought together things that created the bubble.
It is clear that Professor Glaeser does not understand what happened, but there are many people who do understand it. I explained it clearly above, and I will expand more now.
There is a mechanism by which prices are inflated. Prices do not increase by magic. A borrower is given a loan by a lender to buy real estate. The standards the lender applies and the terms of the loan determine who gets the loan and how big it is. It isn't mysterious; It is how our housing market works. All causes of the housing bubble must be explained by their impact on loan terms and standards. In fact, the failure to make this link is the weakness of all housing market analysis based on macroeconomic conditions.
There is a basic connection between what individuals do and the results of the collective actions of individuals. Individual borrowers taking out very large loans from stupid lenders bid up the prices on houses. The collective action of all these individuals is rising market prices and a bubble. I hope everyone who reads this is capable of explaining it to the Harvard professor. All of you now know more than he does.
Diana: But didn't subprime lending drive prices higher by bringing certain fiscally ineligible buyers into the market?
Prof Glaeser: The subprime mortgage market is different than the housing price boom. We think that it did drive prices higher. But even the historical relationship of LTV is a very small fact relative to the boom that occurred.
I pushed the professor on the loose lending some more, and he agreed that it was certainly an ingredient in the cocktail, but not the sole driver of the housing bubble.
One thing I do find interesting about this study is the conclusions they draw from their work.
So what are these researchers are trying to prove? Well that comes at the end of the press release:
While the data do not explain the housing bubble, the authors do contend that "the relatively modest link between interest rates and housing prices makes us more confident about rethinking [other] Federal housing policies," most notably the ability to deduct mortgage interest from federal income taxes, a politically popular policy that many analysts believe is inefficient, unfair, and environmentally unsound .
Prof. Glaeser argues that the mortgage interest deduction is not healthy for the housing market, and, while he didn't say as much, perhaps more dangerous than low, low mortgage interest rates or no-money-down loans. Why? Because it gives borrowers a continuing, long term incentive to borrow more than they should.
How did the home mortgage interest deduction get dragged into this? The professor is correct in his observations, but there is no linkage to his study. If the HMID somehow inflated the bubble, the argument would have greater strength, but since it didn't, the professor's argument looks like a pet idea he included because he couldn't figure out what really caused the bubble and what anyone could do about it.
The truth is lenders giving out Option ARMs and other toxic loans enabled borrowers to inflate prices, and the Desire for Mortgage Equity Withdrawal Inflated the Housing Bubble. The evidence is clear. And the government's response to the problem with HAMP is simply bringing back the Option ARM. Temporary interest rate reductions and principal deferment are the two characteristics of Options ARMs that made them unstable, yet that is the cornerstone of the government's loan modification program.
If the professor wanted to analyze the problem and suggest a change in government policy, he should go after the ridiculous bailouts and loan modification programs rather than proposing a battle against the politically impossible to repeal HMID.
Problem solving begins with a clear grasp of the problem. If the problem is not defined correctly, all solutions that follow are likely to fail. So far, we have defined the problem as foreclosure, so all our solutions are designed to delay or prevent foreclosure, and they have all failed. In reality, our problem is too much debt, and foreclosure is the solution. When policy makers finally realize this, perhaps they will get out of the way and allow the cleansing foreclosures to go forward. We can only wait and hope.
According to the listing agent, this listing may be a pre-foreclosure or short sale.
This property is in backup or contingent offer status.
Attention Investors!!! Attention Buyers!!! Looking to Start 2010 with a Bang? Want the Deal of the Year? Nestled in Irvine s Prestigious Northpark Square & Priced to Steal, this HANDSOME Residence boasts STUNNING CURB APPEAL & LUXURIOUS Comforts that Surpass Every Home in this Price Range! Spacious Open floor plan offers 5 Bedrooms & 4 Baths w/2-Car Garage in approx. 3,537 sq.ft. Inviting Living Room & Elegant Dining Room is perfect for Entertaining. Gourmet Kitchen w/Granite Counters & Chef s Island opens to generous Family Room & Breakfast Nook. Spacious Master Suite w/Huge Walk-in Closet plus Large Secondary Bedrooms offers Abundant Closet Space! Wait till you see the HUGE Bonus Room. Near Shopping, Dining, Entertainment & Schools including community Pool, Spa, BBQ s, Sports Courts, Outdoor Amphitheater, Parks, Walking Trails, Bike Trails, Tot Lots & More! Make No Mistake This Home Will Not Last, So ACT FAST! Only ONE like this!!!
That is one of the worst descriptions I have read in quite a while. I ran out of room for graphics. it has almost every convention of bad realtor writing in one paragraph. Stunning!
Defaulting owner
This property may be facing foreclosure due to unemployment. The owner paid way too much back in 2005, but he put $229,600 down. He refinanced and pulled out a little, but he still stands to lose $200,000 when this property sells. He is trying to short sell, and squatting until it happens:
America inflated a massive housing bubble, but the Irish managed to build so many excess houses that they could house every Irish citizen and still have many left over.
Building houses that remain unoccupied is a terrible waste of societal resources. Houses are expensive. When we put hundreds of thousands of dollars of sticks, bricks, and labor into something of no benefit to anyone we get a temporary economic boost from the construction itself, but when no use if made of the final product, it is all a complete waste. We could have sent a hundred laborers out to dig holes then bury them back up and accomplished the same nothing.
This cycle repeats in California. In the early 90s, we had many excess housing units in fringe markets like we do today. The markets are different as the fringe markets moved eastward, but the effect is the same. There are many empty McMansions in eastern Riverside County, the High Desert and in housing markets all over the country.
For as stupid as we were here in the United States, the Irish make us look prudent and restrained.
David McWilliams is the man who coined the phrase "ghost estate" when he wrote about the first signs of a disastrous over-build in the Irish Republic back in 2006.
Now, it is a concept the whole country is depressingly familiar with. Most Irish people have one on their doorstep – an ugly reminder, says the economist and broadcaster, of wounded national pride.
"Emotionally, we have all taken a battering," he says. "Like every infectious virus, the housing boom got into our pores. You could feel it.
"You'd go to the pub and people would be talking about what house they'd bought. And now a lot of people, myself included, think 'God, we were conned'."
The Irish have reached a state of capitulation. We haven't. Most people you talk to here in California really believe house prices have bottomed and they they will appreciate back up to the peak in a couple of years. The totality of our failure has not reached the masses. In Ireland it has.
'Emotional thing'
Mr McWilliams paints Irish history as one of "economic failure".
"So to have risen so quickly and seemingly in the right direction and then to have that pulled away from us," he says, "it's more of an emotional thing than a financial thing."
That is the root of much denial in our own market. Failure is difficult to admit. Many people bragged about their financial genius and convinced others to participate in the madness. Now they find themselves hopelessly underwater and unable to admit their error. They cover it with anger and condescension.
There are 621 ghost estates across the Irish Republic now, a legacy of those hopeful years. One in five Irish homes is unoccupied.
If the country immediately used them to house every person on the social housing list, there would still be hundreds of thousands left over.
OMG! Empty out the homeless shelters by putting them into McMansions, and they still couldn't fill their housing stock. Squatting is not a problem there, I guess. Who would know or care?
It is difficult to comprehend that level of overbuilding. I remember living in Texas in the early 90s, and I was astonished at the number of empty office and retail spaces. They built a 20 year supply in a few years. Strip malls and office buildings were everywhere — all of them empty. It must be rather eerie to drive through modern subdivisions of empty houses.
The obvious question of who people imagined would live in all these new-builds makes Irish people wince now.
But hindsight is a wonderful thing. Only a few years ago, developers feeding money into local government coffers were getting free rein to build row upon row of five-bedroom detached houses on the green outskirts of towns nobody had even thought of commuting from before.
'Raised eyebrows'
Banks were throwing money at members of the public who saw these houses either as an escape to a better lifestyle or an investment route to riches.
Builders from eastern Europe were working overtime to create homes, the value of which was sometimes three times what it is now.
Sound familiar, doesn't it. How many people bought second homes for their retirement — houses that were to actually provide for that retirement with the inevitable appreciation? Everyone in California was a speculator, and many (if not most) took out this appreciation and spent it like income.
Instead of eastern Europe, we imported our labor from northern Mexico to build houses worth about a third to a half of what they were a few years ago. The pattern is the same, it is only a matter of degree.
As the slump set in, the immigrant workers went back home, the banks ceased lending on the scale that had fueled the frenzy and the market disappeared.
Property supply had become completely divorced from property demand.
County Leitrim alone would have needed about 590 new houses between 2006 and 2009 to accommodate its population growth. It got 2,945.
That sounds like most of the fringe markets here in the US. There are many small towns about 90 miles out of downtown Phoenix that saw huge numbers of empty homes built. South Florida is a wreck.
[empty neighborhoods in Ireland]
The resulting mess is currently being addressed by a nationwide audit of empty and unfinished housing.
It has raised eyebrows that precise numbers are not already clear, even to the local councils who gave planning permission for the homes in the first place.
'Everyone was buzzing'
Ciaran Cuffe is the Green Party minister of state in charge of the audit.
"It's one heck of a challenge", he says, "because we have the legacy of many years of poor planning, and an economy that was overheated, paid far too much attention to construction and was more interested in the quantity than the quality of homes".
Fortunately, we have stringent building codes here, and most of the bubble era construction is very good; however, we certainly got much more than was required.
He says the state's perceived wealth was part of the problem.
"I think there was a view that demand would continue indefinitely at a time when we had very high levels of immigration.
"People thought the housing was needed not only for the people of Ireland but also for others that had come here, and that this golden goose would continue to lay golden eggs for ever."
No matter how it is cloaked, the illusion of permanent prosperity is associated with every financial bubble. The roaring twenties saw a land boom and bust in Florida — there was only so much buildable land there, so certainly it would rise in price forever. We followed that with a stock market bubble built on the belief in the prowess of American industry. In the stock market bubble of the 90s, people thought tech stocks, semiconductors in particular, would rise forever. We were entering a new era driven by technology, or so we thought.
Nobody expects the majority of the Republic's surplus new housing simply to be ploughed down by the bulldozers now.
But Mr Cuffe admits some of the recent headlines in the Irish press on the subject are not completely wide of the mark.
"I certainly think demolition could be part of the solution in cases where we have housing estates that are unoccupied, that are miles away from where people want to live and that were badly built in the first place."
It is rare that houses are bulldozed, particularly new construction. Perhaps 40 year-old crack houses in Detroit, but new McMansions will be occupied by someone even in remote locations.
And indeed, many of the Irish ghost estates are in the unlikeliest, most isolated places.
It is strange, looking down vast rows of immaculate new-builds, taking in their optimistically-planted front gardens and peering through curtain-less windows into unwanted granite-topped fitted kitchens, to comprehend the fact that they might never be occupied.
Mr McWilliams says the whole of the Irish Republic is having to come to terms with what he compares to a collective addiction.
"Everyone took the property drug at the same time", he says, "everyone was up at the same time, everyone was buzzing.
"Now we are all in the middle of this huge comedown. And people are looking around and saying – 'what happened? Was that us?' And then we look at our bank statements and we realise – 'yes, it was'".
The end of a financial mania has all the symptoms of a severe hangover. Nothing is free in life, and when people act like it is, when they become entitled, life has a way of slapping them in the face.
Look at what the housing bubble has already done to our population. We have created a massive sense of entitlement, and everyone still wants to own a home — not because it is a place to shelter their family, but because they see it as their own personal ATM machine capable of giving them everything their greed desires. Lenders try to take advantage of this foolishness and give people huge mortgages. Those that sign up get to live a life of servitude endlessly feeding the beastly lenders. Those of us who do not want to play the HELOC game have to pay a 30% premium to provide shelter for our families because the ignorant HELOC abusers bid up prices. Great system.
Routine HELOC abuse
I have looked at enough of HELOC abuse properties to become convinced that HELOC abuse was considered a wise financial management tool by a broad cross-section of Irvine home owners. Day after day after day, I profle these. I have to go out of my way to find someone who didn't spend their home.
Hey, sellers, contact me if you didn't abuse your HELOC, and I will profile your property and call attention to your good behavior. A responsible borrower is hard to find.
Today's featured property was purchased on 12/22/2004 for $610,000. The owners used a $488,000 first mortgage and a $122,000 second mortgage. There was no down payment.
On 2/13/2007 they refinanced with a $588,000 first mortgage and a $73,500 second mortgage.
Total property debt is $661,500.
Total mortgage equity withdrawal is $51,500.
Total squatting is at least 6 months so far.
Foreclosure Record
Recording Date: 02/03/2010
Document Type: Notice of Sale
This isn't a bad case by Irvine standards, but then again, they did buy late into the bubble. While the rest of us were paying for our housing, their house was paying them.
According to the listing agent, this listing may be a pre-foreclosure or short sale.
This property is in backup or contingent offer status.
NO Mello Roos! NO HOA dues! Award winning Northwood schools in Irvine. Walking distance to elementary. This beautifully upgraded home features 3 spacious bedrooms plus an office/den with built ins – could be converted to 4th bedroom, and 3 full bathrooms. Home upgrades throughout, bath surround tiles in showers, tile flooring, newer roof less than one year, spacious backyard, premium corner lot site and quiet neighborhood across to park. Convenient location with easy access to major freeways, employment hubs, shoppings and entertainment.
For all our wisdom and collective experience, none of us knows what the markets will do next. Like an ocean current or a raging river, a financial market charts its own course. It is fickle and feckless and flows without regard to our hopes and dreams. The ebbs and flows of financial markets are meaningful to us, but in reality they are just movements in price; nothing more. Price rallies make homeowners blissful and renters bitter, while price declines make homeowners gloomy and renters gleeful. These feelings and emotions are independent of movements in price. The market just moves, that is all it does. It is benign, yet dangerous; it is indifferent, yet demonstrative; the market is a paradox which we must simply accept.
During the rally of the Great Housing Bubble, buyers did not concern themselves with the day they were going to become sellers. Why would they? There was an endless demand for properties, and buyers were paying whatever was asked. If they wanted a price above current market values to pay off a loan, all they had to do was wait. Once the bubble burst and home prices started to decline, the conditions people were accustomed to during the rally dramatically changed. Anyone considering buying a home in the aftermath of a crash should think about the buyer who is going to buy their home from them at some point in the future, and more specifically, what debt-to-income ratio and loan terms this future buyer will utilize. This is important, because the amount of money this take-out buyer will pay for the home is completely dependent upon these variables. At most, a house is only worth what a buyer can pay for it.In a declining market with few qualified buyers, many of those qualified buyers will only make offers if the deal is exceptional or simply wait for further price declines.
In a market environment where prices are detached from fundamental valuations, bubble buyers face a daunting challenge just to break even on their purchase when the time comes to sell it. A future buyer must have favorable borrowing terms allowing for a high degree of leverage or they may not be able to borrow the prodigious sums borrowers during the bubble rally were able to obtain. If a future buyer is not able to borrow as much with their income as bubble buyers, then wages must increase over time to permit future borrowers to borrow the same sum and allow a bubble buyer to avoid a loss. Unfortunately, it will take many years for wages to catch up to bubble prices. Even when this occurs, and a seller can recover their purchase price, inflation will have diminished the value of those dollars. If the prices are adjusted for inflation, many bubble buyers will never see an inflation adjusted breakeven price.
How Far to Fall
This book was written as the market crash was just beginning, and although there was already significant history to discuss, the price levels where the markets ultimately found stability had not yet been reached. The remainder of this chapter is a projection of what should happen if the residential real estate market responds as history would suggest. There will undoubtedly be unexpected twists and turns that impact the various variables influencing housing prices, and changes to these variables will change the timing and the depth of the crash. The projections and discussion which follows is based on first a return to historic norms and finally a look at what could happen if the crashing market causes an “overshoot” of fundamental valuations as often occurs in the collapse of a financial bubble.
All methods of predicting future price action rely on the same basic premise: prices are tethered to some fundamental value, and although prices may deviate from this value for extended periods of time, prices eventually return to fundamental valuations. This premise has been reinforced by market observation; in fact, many estimates of fundamental value are based on market action. Since many market participants believe in buying and selling based on fundamental values, there is also an element of self-fulfilling prophecy contained therein. The efficient markets theory is based on this idea, and although the behavioral finance theory is needed to explain the wide deviations from fundamentals real-world prices exhibit, both theories share the same notion of an underlying fundamental valuation on which prices are ultimately based. The challenge to market prognosticators is to select a fundamental valuation to which prices will return, and then extrapolate a period of time in which the return of prices to fundamental valuation will take place.
There are a number of ways to project how far and how fast prices will fall. One is to look at the price charts themselves and try to project reasonable trend lines to approximate bottoming valuations. This is not an accurate methodology as it is based on the assumption of a repetition of past performance without examining the reasons for this past performance; however, it does serve as a useful rough estimate. A more accurate and detailed method is to examine the variables that determine market pricing and see how changes in these variables impact resale values. This process involves assessing current fundamental values to make a statement as to where prices should be–and would have been if there had not been a residential real estate bubble–then estimating how long it will take for these variables to return to their historic norms. Also, there are a number of exogenous forces that act on market pricing in an indirect manner. These include debt-to-income ratios, availability of credit and changes in loan terms, mortgage interest rates, unemployment rates, foreclosure rates, home ownership rates, possible government intervention in the markets, and other factors. These forces do not directly impact house prices as changes in these variables do not have strong correlation with house prices; however, these variables can and do impact the variables that do correspond with house prices, therefore an evaluation is provided of the role these factors play in market pricing.
The timing of the decline is the most difficult parameter to evaluate and estimate. [1] House prices are notoriously “sticky” during price declines because sellers are loath to sell at a loss. The timing of a decline is impacted both by psychological and technical factors. The motivations of sellers based on their personal circumstances and emotional states will determine if there is a heightened sense of urgency to sell which would push prices down quickly. During the price correction of the coastal bubble of the early 90s, prices declined very slowly as unmotivated sellers held on and waited for prices to come back. The market experienced denial and fear, but there was not a stage of capitulatory selling that drove prices down quickly as is typical in the deflation of a speculative bubble. The primary technical factor impacting the rate of price decline is the presence of foreclosures and real estate owned (REO). REOs are a form of must-sell inventory (as are new homes). If there is more inventory of the must-sell variety than the market can absorb, prices are pushed lower. The more of this must-sell inventory there is on the market, the faster prices decline. If the pattern of the early 90s is repeated, the price decline of the Great Housing Bubble may drag out slowly while fundamentals catch up to market pricing. In fact, this is probably what will occur on the national market unless the foreclosure numbers and resultant REOs overwhelm market buyers. In the extreme bubble markets like Irvine, California, the combination of high foreclosure rates and general market panic will likely push prices lower much more quickly. [ii] Even though the percentage decline in house prices is projected to be double the decline witnessed in the coastal bubble of the early 90s, the duration of the decline may be similar as capitulatory selling pushes prices lower at a faster rate.
Price Action
Most market participants focus on price action. The price-to-price feedback mechanism largely responsible for bubble market behavior gathers its strength from an awareness of market pricing, and the widespread belief that short-term, past price performance is predictive of long-term, future price performance. It is a fallacy that is often reinforced in the short-term as irrational exuberance takes over in a market, but over the long term, short-term price movements rarely correspond to long-term price trends, and when they do, it is only by chance.
Predicting future prices based on price action is based on the premise that long-term price trends are reflective of fundamental valuations because they represent the collective wisdom of the market. As with all methods of predicting pricing, deviations from the long-term fundamental valuation almost always result in a return to this value. The weakness in this theory is in its failure to provide a causal mechanism. To note that prices return to long-term valuations without postulating why prices do this provides no mechanism for estimating when prices will return to fundamental value, and it provides no way to determine if there is a significant change to the market’s valuation to establish whether or not prices will return at all. In short, past price action itself is very limited in its ability to predict future price action. Despite the shortcomings of the methodology, predictions based on past price performance are widely used and often woefully inaccurate.
Figure 36: National Projections from Historic Appreciation Rates, 1984-2012
From 1984 through 1998, national house prices appreciated at a rate of 4.5%. There is a strong correlation between this rate of price increase and observed market prices. There is only one deviation from this rate of appreciation during the period. The effect of the coastal bubble of the late 1980s on national prices creates a small rise from the historic appreciation rate and a sideways drift of prices until values resume their 4.5% annual rise. Since prices consistently match this rate of appreciation, and since prices deviate once from this rate in a prior price bubble and return to it, there is a compelling argument that prices will drop to this level of long-term appreciation and begin rising again. If this proves to be true, national home prices will decline 10% from the peak, bottom in 2009, and return to the peak by 2011. This is the market’s best-case scenario.
Figure 37: Irvine, CA, Projections from Historic Appreciation Rates, 1984-2026
The story for the most inflated markets such as Irvine, California, is much the same as the national forecast. If the 4.4% rate of appreciation seen from 1984-1998 is repeated, then prices will decline 45% from the peak, bottom in 2011 and return to the peak in 2023. Since prices peaked in 2006, this method of price projection shows an 18 year peak-to-peak waiting time: not a comforting forecast for Irvine homeowners.
Figure 38: Growth in Income and House Prices, 1981-2006
The key assumption in this analysis is that market prices will resume the rate of appreciation seen from 1984 to 1998. This rate of house price appreciation is 1.4% above the rate of inflation, 1.2% above the rate of wage growth, and 0.7% above the very long-term rate of house price appreciation. House appreciation cannot exceed wage growth forever: trees cannot grow to the sky. People have to earn money to buy a home (unless of course we become a nation of the landed gentry in which real estate is only transferred through inheritance). Over the last 25 years, house appreciation in Orange County has outpaced wage growth. Wage growth has averaged 3.4% while house price appreciation has averaged 6.9%. The coastal bubble years (1986-1989) where house prices outpaced income growth were followed by bust years (1990-1995) where wage growth made modest recoveries.
House prices outpaced wage growth for two reasons: first, debt-to-income ratios rose as people put higher percentages of their income toward making payments; second, interest rates declined allowing people to finance larger sums with less money. Much of the reason house prices appreciated at a rate in excess of its normal relationship to inflation is due to the gradual decline of interest rates during the period. As interest rates decline, the amount people can borrow increases. If people can borrow more, they can bid prices higher. House prices appreciated at a rate greater than its long-term average due to declining interest rates. If interest rates stop declining (which is likely), or if interest rates begin a cycle of long-term incline, the rate of house price appreciation will be impacted negatively; the drop of prices from the deflating bubble will be deeper, and the date of ultimate price recovery will be much later.
Figure 39: Declining Interest Rates, 1984-2006
The median sales price measures the general price levels at which buyers are active in the market, but it does not reflect the quality of what is purchased and it does not reflect the price changes of individual properties. The S&P/Case-Shiller indices measure price changes in individual properties through its use of repeat sales in calculation of the index. Market participants are primarily concerned with how their property is changing in price rather than some aggregate measure of the market. The S&P/Case-Shiller index is the best market measure for approximating the price change on individual properties.
Figure 40: National Projections based on S&P/Case-Shiller Indices
It is more difficult to use an aggregate appreciation rate on the S&P/Case-Shiller indices because there is no single period where a particular average correlates well with market pricing, plus small changes in the rate of appreciation can make large differences in where the bottom is found. There are two issues to be addressed with any projection of appreciation when there is low correlation to the data: the starting point, and the rate of increase. The S&P/Case-Shiller indices did not start collecting data until 1987, but this date is arbitrary. The most recent market low was in 1984, and by 1987, there was some detachment from fundamental valuations. The point of origin for the projection of appreciation may more appropriately be below the first data point in 1987; however, to simplify the analysis, the 1987 data point was used as the origin. The 3.3% rate used in the projections was the historic rate of wage growth from 1987 to 2006. Since people finance house purchases with payments made from wages, this is a reasonable rate to use. Another method that can be used is to assume the very long-term rate of appreciation of 0.7% over inflation. The question then is what rate of inflation should be used. The average rate of inflation from 1987 to 2007 has been just over 3%, but inflation rates have been much higher and more volatile prior to this time. So an argument can be made that 3.7% is a more appropriate number. If this rate is used with the lower origin point to allow for the small degree of house price inflation already evident in 1987, the two support curves differ slightly, but the difference between the two is not significant to the outcome.
Figure 41: Los Angeles Projections based on S&P/Case-Shiller Indices
Based on projections from S&P/Case-Shiller indices using a 3.3% rate of wage growth as a support level, prices of individual properties will decline 27% from their peak valuations in 2006, finding a bottom in 2011 and reaching the previous peak in 2025. This is arguably the market prediction of most concern to homeowners that purchased during the bubble because it reflects the price change of individual properties like theirs. There is very little comfort in the thought of a 27% decline and a 19 year waiting period until prices regain their previous peak.
The degree of detachment from fundamental valuations in the extreme bubble markets like those in California is truly remarkable, and the decline in house prices will be as unprecedented as the rally that preceded it. Based on projections from S&P/Case-Shiller indices using a 3.3% rate of wage growth as a support level, prices of individual properties will decline 53% from their peak valuations in 2006, finding a bottom in 2011 and reaching the previous peak in 2033. Twenty-Eight years is a long time to wait for peak buyers to get their money back.
Price-to-Rent Ratio
Comparative rent is the primary method of evaluating the fundamental value of any property. The price-to-rent ratio links the cost of ownership with the cost of rental. This link is direct because possession of property can be obtained by either method. The cost of ownership encapsulates all of the financing terms and other variables associated with possession of real estate as does the cost of rental. Price-to-rent ratio fluctuates over time as changes in the cost of ownership and terms of financing makes financing amounts vary and house prices vary as well.
Figure 42: Projected National Price-to-Rent Ratio, 1988-2021
Figure 43: National Projections based on Price-to-Rent Ratio, 1988-2021
One of the major components of any projection using price-to-rent ratios is the projection of future rents. On a national level rents have been rising at a 3.6% rate from 1988 to 2007. [iii] This is 0.6% greater than the rate of inflation and 0.3% greater than the rate of wage growth. In Orange County, California, rents have been rising at the rate of 4.7% from 1983 to 2007. This is 1.7% greater than the rate of inflation and 1.3% greater than the rate of wage growth. Any difference between the rate of rental growth and the rate of wage growth cannot be sustained forever; however, the differential on the national level is small, and it can be attributed to changing customer behavior as people demonstrate an increased willingness to spend more on housing related costs. The rate of rent growth over wage growth in Orange County is a bit more troubling. Orange County is second only to Honolulu, Hawaii as the most expensive place to rent in the United States and the continued growth of rents in excess of wages is not sustainable.
The unprecedented spike in the national price-to-rent ratio is clear evidence of a massive, national real estate bubble. As the ratio demonstrates, there was no increase in rents justifying market pricing. The only other explanation which would deny a market bubble would be a dramatic lowering of ownership costs through other means. Although lower interest rates did lower ownership costs somewhat, the resulting savings due to lower interest rates only explains about one-third to one-half of the increase in prices. The remainder is caused by the use of exotic financing and irrational exuberance. Predictions based on the price-to-rent ratio are arguably the most robust because the ratio has been stable over long periods of time, and for good reason; the comparative cost of ownership to rental is a logical basis for valuation. If house prices return to their historic average of the 1988 to 2004 period of 181, then national prices will fall 27% peak-to-trough, bottom in 2011 and return to the peak in 2020.
Figure 44: Projected Orange County, CA Price-to-Rent Ratio, 1983-2020
The ratio of price-to-rent in Orange County, California, where the city of Irvine is located, has shown more variability than national figures. There was a coastal bubble taking off in the late 80s and collapsing in the early 1990s. The premise of prices reverting to fundamental valuations can be clearly seen in the changes in the price-to-rent ratio in Orange County. In the mid 1980s, the market was bottoming out from the first coastal residential real estate bubble associated with the inflationary times of the late 1970s. From 1983 to 1987, the price-to-rent ratio stabilized between 176 and 185, a range of about 6%. After the coastal bubble, prices stabilized in 1994 to 1996 in a range from 175 to 178. Projections using the price-to-rent ratio assume prices will fall again to the range from 175 to 185 before stabilizing. The reason prices stabilize in this range is because it is here that the cost of ownership approximates the cost of rental, and Rent Savers buy real estate and form a support bottom. If house prices in Orange County return to their historic price-to-rent stability range, prices will fall 22% peak-to-trough, bottom in 2013, and return to the previous peak by 2019; however, if rental increases do not sustain their 4.7% historic rate, the bottom may be somewhat lower, and the return to the previous peak would be delayed.
Figure 45: Orange County Projections based on Price-to-Rent Ratio, 1988-2020
[1] Since real estate is associated with high transaction costs, heterogeneity and illiquidity, there is little opportunity for arbitrage (Black, Fraser, & Hoesli, 2006) (An investor cannot sell a house short.) These factors cause house prices to correct slowly without large numbers of foreclosures.
[ii] Large variations in regional markets suggests the markets will deteriorate at different rates and at different times. (Baker D. , 2002) The extreme bubble markets of the coasts will deteriorate the most, and they may deteriorate the fastest due to the profusion of exotic financing.
[iii] Rental data is from U.S. Department of Labor Bureau of Labor Statistics.
The posts this week left me feeling a bit uneasy. I am afraid I have unleashed a financial weapon of mass destruction. I was both amused and disturbed when I reasoned through the problem and figured out what I had done.
I have been contacted by a few readers and confidants more knowledgeable in banking and finance than me, and they have expressed their concerns over this idea. Not because it won't work, but because it will.
I didn't set out with the goal to discover a way to short real estate and crush the banks. I was merely exploring options for finding good renters on Inland Empire properties. Ideally, the portfolio manager wants a renter who feels like they own the place so they will take care of it and never leave. The former owner is a natural rental candidate. Even after considering the former owner, I didn't fully realize what would happen until I asked myself, "what would make an owner pay more in rent and stay on longer?" The obvious answer was to give them the option to repurchase their home later once their credit improved. When the purchase option came to me, I saw the short trade and the huge incentive to walk away it creates. It frightened me.
The only thing really keeping underwater home owners from defaulting in large numbers is the belief that they will need to leave the property. Once borrowers believe they can stay in their homes and have their housing costs reduced to rental rates, it's over. They will all walk.
If a big money player began doing this on a big scale, and there is no reason it couldn't be scaled up nationally, it will crush the banks, the housing market, and in the short term, the national economy. Personally, I think it would be a great thing for the long-term prosperity of the country because the excessive debt serves no one, but short term, much pain will be involved.
I'm not quite sure what to do with this idea. Perhaps I should do nothing. Perhaps I think it is more dangerous than it really is. I don't know. I feel a bit like Robert Oppenheimer or Alfred Nobel, both of whom did create weapons of mass destruction and lived to regret it.
The thing is, if I were operating a fund in Riverside County buying properties, I would be doing this. My fiduciary responsibility to the fund would demand it. It would be irresponsible to turn away a good renter who would treat the property well and pay more for it. It is quite an interesting set of circumstances.
What concerns me the most is the pressure this will put on banks for principal reductions. Principal reduction without foreclosure is the worst of both worlds — it rewards HELOC abusing squatters without doing much to lower prices. It would be less expensive for the banks than having the Cartel Crusher convince everyone to default because they can control the damage and prices will remain higher with fewer sales, the current status quo.
Turning Cartel Crusher into Family Home Savior
It was fun writing about the Cartel Crusher from the point of view of anger toward the banks, but the Cartel Crusher will be worshiped as a godsend by loan owners in default. Cartel Crusher will keep more owners in their homes than any government program or bank loan modification program. It is true redemption for hopeless borrowers. I may write a post for next week renaming the Cartel Crusher and portraying it as something soft and fuzzy and a little messianic. Whatever its called, loan owners are going to love it.
I'm not really that angry
I want to share a little secret. I laugh at my own material. My wife thinks I am goofy as I sit at my computer and break down laughing. My favorite sequence from last week sounds very angry — with a little help from Arnold Schwarzenegger — but every time I read it, I burst out laughing:
What is best in life?
To crush the banks, see them driven into oblivion, and to hear the lamentation of their bondholders.
And although Monday seems like ages ago, I also enjoyed this cartoon:
It is difficult to get dialogue that matches the people in the pictures. I'm never quite sure if others see the same personalities I do, or if I capture the essence I seek. My best effort of the week was inspired by Soylent Green Is People. It took me several iterations to get the dialogue right and to sequence it to be easy to follow.
It wasn't many years ago that when you saw a $3,000,000 home, you knew the owner probably owned it outright or with a minimal mortgage. Mortgages over $1,000,000 were not common because (1) borrowers didn't want them because they can't deduct all the interest, and (2) banks didn't want to underwrite them because so few borrowers qualify. Well, we all know what happened to lending standards, so now we have many, many high-end properties with enormous loans. A classic example of bubble inflation.
The high end is not stable. There is too much debt and too many pretenders that invaded these wealthy neighborhoods and drove up prices. Now they are squatting because the banks can't afford the write downs. From what I observe, the upper middle class is obtaining the greatest benefit from the amend-pretend-extend dance.
The loan owners occupying today's featured property borrowed $3,199,000 of their $3,474,500 purchase price. That is only $275,500 down. They could have made that selling a condo in 2006. So it isn't like they ported a great deal of equity into the property. No, they pretended and borrowed it.
To make matters worse, Washington Mutual loaned them $3,350,000 in a refi on 10/31/2007. WTF were they thinking? In the end, these borrowers had only $125,500 of their own money in a $3,474,500 property.
When people are successful and "arrive" they are supposed to do it with cash. Californian's arrive early with borrowed prosperity and fake it until they either make it or experience the The Unceremonious Fall from Entitlement.
The success of pretenders is amazing. Other people really believe California is a land of endless wealth. It is all an illusion. Did you know that almost 80% of the BMWs and Mercedes on the road are leased? That is pretending.
According to the listing agent, this listing may be a pre-foreclosure or short sale.
Views! Views!! Views!!! One of the Most Spectacular View Homes in the Summit at Turtle Ridge! Charming Indoor and Outdoor Spaces Created around a Central Courtyard. Open Air Dining Loggia with Fireplace Provides a Glimpse of this Home's Brilliant use of Outdoor Space. Gourmet Kitchen and Pantry with Top-of-the-Line Appliances. Luxurious Main Floor Master Bedroom and Bath with Spectacular Views. Great Room with Fireplace, Opens to a Beautifully Landscaped Backyard with Gorgeous Views. Extra Large Bonus Room leads to the Central Court Yard. The Casita, a Completely Separate Living Suite with a Fireplace, is Generously Sized, creating a Private Oasis. Super Size Laundry Room, Four Car Garage, Travertine Floors, Upgraded Carpet, Granite Counters, and Many More Upgrades, add to the Luxury and Comfort of this Home. Upstairs includes Bonus Room, Two Bedrooms, each with Views and Full Baths, and a Separate Living Room with Kitchenette and Private Access to the Outside.
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